Sebi and risk management: issues to be considered (Management Issues)

 Readers should note that the report is source-based and hasn’t been officially confirmed by Sebi.Even so, these issues are important and require the regulator’s attention. The suggestion of pre-trade order limits is interesting. Currently, exchanges follow the practice of alerting its trading members when they exhaust a certain percentage of the margins deposited with the exchange. This works as a reminder to deposit additional margins before they exhaust the 100% mark and are blocked from taking fresh positions. There has been a concern that thanks to algorithmic trading, the exchange’s system may receive a large number of orders in the time between the trading member reaching the 100% mark and the time by which exchange blocks the member’s systems. Given the reality of rogue algorithms, this concern isn’t unreal. The Mint report says that Sebi plans to impose order limits depending on the size of capital deposited by the member, to ensure that large orders don’t enter the system and the damage is limited.Management IssuesBut a better solution is at hand. The National Stock Exchange has started a mechanism, on a voluntary basis, to help trading members manage their risks better and avoid a disablement of their trading terminals. The facility is called a voluntary close-out, which was rolled out for the cash market late last year, and for the derivatives market, only this year. The exchange’s circular states, “This facility enables clearing/trading members to voluntarily define a limit for margins/positions beyond which all the orders would get risk managed.” For example, if the member defines the voluntary close-out limit as 95% of the total deposited margin, the exchange starts treating the member’s orders differently beyond this level. From then on, each order is assessed based on its size and whether its execution will lead to a breach of the position limits. For example, consider a member who has exhausted 95% of its margins and has a margin amounting to Rs. 100 crore remaining. If the member enters an order, which, if executed, will exhaust this remaining margin, it will be rejected by the exchange trading system. An order or even multiple orders which require Rs. 100 crore or less of capital on a cumulative basis will be accepted. While the system is good and fool-proof, it’s important to note that is being followed on a voluntary basis by the exchange.It can be made mandatory to address the problem mentioned above. That way, there will not be any scope for the trading member to breach the set position limit, and put the exchange at risk. Management IssuesThe proposal to mandate segregation of a trading member’s clients’ accounts from the member’s own accounts should be implemented sooner than later. The recent experience with MF Global Holdings Ltd shows how critical the issue is. When the brokerage filed for bankruptcy late last October, it was discovered that a large portion of its clients’ funds had gone missing. Of course, this happened despite strict regulations that exist in the US markets relating to segregation of clients’ assets. But the MF Global experience has shown that the risk of clients losing out when their broker goes bust is real. If the segregation rule is followed, like it was in the case of Lehman Brothers Holding Inc.’s broking subsidiaries, client money will be safe. Thanks to the MF Global experience, the Indian regulator can now frame policies that ensure that the segregation rule is actually being followed. In the US markets, there is a fair bit of self regulation, and touching clients’ funds was considered to be out of the question. But it’s best to frame rules assuming that there are people out there who will look to flout them.Sebi has been talking about allowing interoperability between clearing corporations for about a year now. This will allow trading members the option of clearing trades with a clearing corporation of their choice. This will result in efficient use of capital for trading members who take positions on multiple stock exchanges, as some of their positions may be offsetting in nature. There are other benefits as well for market participants. At the same time, it must be noted that making interoperability work isn’t a trivial issue. If a fail-safe legal process is not in place, interoperability will introduce the risk of contagion, where one troubled clearing house can bring down others. Thus, the regulator will have to put down thorough legal and operational framework, which is likely to take time. After all, interoperability has just about started being rolled out in Europe, after some considerable ground work in the past few years. These issues have been discussed in this column in detail in the past. Management Issues